Isle of Risk

Last decades, our perceptions of Financial Risk haven been constantly changing and - for sure - they will continue to do so in the future.

In the sixties and seventies of the 20th century 'risk' was mainly plain 'technical risk'. Risk Management was mainly used to support current strategies, as a defensive instrument.

More de-Tailed studies of risk in the nineties, created new instruments and models to manage (investment) risks. This led to the understanding that it was possible to take more risk because we could understand and manage it in a better way.

Next, at the beginning of the 21th century, these new risk models were expanded and transformed from passive to active instruments. New products and markets were developed by combining, cutting and mixing traditional asset products (stock, bonds, mortgages) with derivates. And just like in chemistry, where mixing innocent individual molecules could lead to an explosive new molecule, the asset markets got flooded with toxic, unknown risk-correlated products.

For most of us it became clear that it was not the risk ingredients (bonds, stocks, derivatives, etc) themselves that caused this turmoil, but our own (irresponsible) behavior, e.g. the way we ourselves were managing the asset products and models. Behavioral Finance was born.

After we poisoned the investment market landscape in the second half of this last decade, things turned for the worse. Instead of looking what we had done, where we were on the risk map and how we could clean up this mess, we kept on building debt and - except for sub prime mortgages - refused to restructure the market 0r to restrict the use of derivatives.
No restrictions nor ethical guidelines on making money just from money (who pays for making money of money?).

Instead, with the latest development High Frequency Trading (1,000 orders per second ! ), covering about 60% of all U.S. equity trading and nearly half of U.S. futures trading, we finally lost our site on what is ethical or not.
Main question is: Who has the guts and the power to stop this development?

Anyway, it's clear that our 'behavior' and a 'map of the risk landscape' are critical in understanding where we are heading with Risk......
Let's start with behavioral finance

Behavioral Finance
One of the world’s best experts in the field of behavioral finance is James Montier.
His book Behavioural Finance is a classical must-read.

In a 2002 classic report titled 'Part Man, Part Monkey', Montier gives a number of common mental investment pitfalls. Here's a sum up of those pitfalls that might apply to actuaries just as well:

• You know less than you think you do
• Be less certain in your views, aim for timid forecasts and bold choices
• Don't get hung up on one technique, tool, approach or view - flexibility and pragmatism are the order of the day
• Listen to those who don't agree with you
• You didn't know it all along, you just think you did
• Forget relative valuation, forget market price, work out what the stock is worth (use reverse DCFs)
• Don't take information at face value, think carefully about how it was presented to you
  

Trinity of Risk
According to Montier the word 'Risk' is perhaps the most misunderstood concept in finance. In classical finance, risk is identified as the relative price volatility (beta). However that's not what risk really is about. 'Downside risk' (ie loss) is what really matters when it comes down to performance measurement. From an investment point of view, risk can be split up into three interrelated elements, the so called 'trinity of risk':

• Business Risk (risk of business going broke)
  
• Financial Risk (risk of using leverage)
  
• Valuation risk (the margin of safety)
  

Valuation risk is the most tricky type of risk, as is explained in an excellent article 'The Biggest Mistakes in Valuation...' by Donald R. van Deventer from Kamakura Corporation. Here's the wrap up of the top 7 valuation mistakes in a humorous "daily life analogy"

1. The Fake Rolex Watch Mistake
   Ask the investment bank which sold you a fake Rolex what the Watch is worth
2. The Poker Game Mistake
   Ask someone else playing in the same game how you should bet
3. The War of the Worlds Mistake
   Believe in a valuation technique Because everyone else thinks it's true
4. The Cash Card Mistake
   Tell an investment banker exactly how your firm evaluates complex securities
5. The Carton of Eggs Mistake
   Don't check to see if the eggs are broken, just look at the egg carton before buying
6. The "My Brother-In-Law Told Me It Was a Good Investment" Mistake
   Bernie Madoff and the rating agencies
7. The 2+2=5 Mistake
   Technical errors in valuation

Financial Crisis 2008-201x
Back to Montier, who's very clear about the role of Bernanke with regard to the role of the FD in the current

• Ben Bernanke, Washington Post, October 27, 2005
  “There is no housing bubble to go bust.”
• Speech Bernanke FED May 17, 2007
  “We believe the effect of the troubles in the subprime sector on the broader housing market will be limited, and we do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system.”

Montier believes Bernanke missed the boat, had poor ideas on how to recover and on top of this, failed to learn from his mistakes. Montier guesses: There are none so blind as those who will not see!

Happy Investor
For those of you who -after all this - don't succeed in becoming a happy investor, Montier has a simple advice on improving (plain) happiness. Here's the wrap up:

• Don’t equate happiness with money.
• Exercise regularly.
• Devote time and effort to close relationships.
• Pause for reflection, meditate on the good things in life.
• Seek work that engages your skills, look to enjoy your job.
• Give your body the sleep it needs.
• Don’t pursue happiness for its own sake, enjoy the moment.
• Take control of your life, set yourself achievable goals.

Map of Risk
Risk is an interesting and never ending subject of discussion and development. Drawing a map of Risk, literally helps you to oversee the Risk battlefield. Draw your own map of risk in life to remember where you are, where you've been and where you'll be heading.....

To help you get on the way, take a look at my Isle of Risk

(click the image for a larger image)

James Montier's Links
- Google Book Behavioural investing
- Was It All Just A Bad Dream? (febr. 2010)
- The Little Book of Behavioral Investing
- Applied behavioural Finance (pdf presentation)

Other links:
- High Frequency Trading Is A Scam
- High Frequency Trading Youtube
- FT: Markets: Ghosts in the machine
- High Frequency Trading -- Results from Simulation

Model Collective Behavior?

Take a look at the next picture:

It's clear that the little fish here, have a problem.

What's also clear, is that random actions of an individual fish are not likely going to change the situation.


In the next picture, by coordinating behavior, a way has been found to solve 'the problem' :



This solution looks very simple, the question is how to organize this kind of collective "big fish" behavior?

The problem is that often first movers will not benefit from a collective approach:

It turns out that one way to get individuals to coordinate their behavior is through morality.

Interested?
In an excellent essay called A Business Plan for Catalyzing Collective Action , The Point explanes how how these cooperative mechanisms can be created.

Actuarial Models
Collective (organizing) mechanisms are important stuff for actuaries. For example, they play an essential role with regard to all kind of solidarity aspects in pension- and insurance-contracts.

Moreover, collective rational or even emotional behavior often plays a decisive role in our society, as may be clear from the 2009 credit crisis turmoil and the escalating bonus madness.

Be aware, study "collective behavior mechanisms" and take them into account when you set up your actuarial risk model.